The Diamond-Rajan Bank Runs in a Production Economy

To analyze the macroeconomic consequences of a systemic bank run, we integrate the banking model `a la Diamond and Rajan (2001a) into a simplified version of an infinite-horizon neoclassical growth model. The banking sector intermediates the collateral-secured loans from households to entrepreneurs. The entrepreneurs also deposit their working capital in the banks. The systemic bank run, which is a sunspot phenomenon in this model, results in a deep recession through causing a sudden shortage of the working capital. We show that an increase in the probability of occurrence of the systemic run can persistently lower output, consumption, labor, capital and the asset price, even if the systemic run does not actually occur. This result implies that the slowdown of economic growth after the financial crises may be caused by the increased fragility of the banking system or the raised fears of recurrence of the systemic runs.

Collateralized capital and news-driven cycles

Kobayashi, Nakajima, and Inaba (2007) show that in the neoclassical business cycle models with collateral constraints, a boom can be generated in response to an optimistic change in expectations on the future state of the economy. They call this business cycle a news-driven cycle. In their models, land is used as collateral, and borrowing for working capital is limited by the value of collateralized land. We simplify their model to the one without land. We show that in the economy where capital goods are used as collateral, the news-driven cycles can be generated.

"Bank Distress and the Borrowers' Productivity"

In this paper, we propose a theoretical model in which a banking crisis (or bank distress) causes declines in the aggregate productivity. When borrowing firms need additional bank loans to continue their businesses, a high probability of bank failure discourages ex ante investments (i.e., "specialization") by the firms that enhance their productivity. In a general equilibrium setting, we also show that there may be multiple equilibria, in one of which bank distress continues and the borrowers' productivity is low, and in the other equilibrium, banks are healthy and the borrowers' productivity is high. We show that the bank capital requirement may be effective to eliminate the bad equilibrium and may lead the economy to the good equilibrium in which the productivity of borrowing firms and the aggregate output are both high and the probability of bank failure is low.

Is Financial Friction Irrelevant to the Great Depression? - Simple modification of the Carlstrom-Fuerst model -

It is argued that existing theory implies that financial frictions appear as investment wedges. Since data show that the output declines in the Great Depression were mainly due to the productivity declines, it is also argued that financial frictions may not be the primary cause of the depression. By slightly modifying the model of Carlstrom and Fuerst (1997), I show that financial frictions may show up as declines in productivity. This result may restore the relevance of financial frictions to the Great Depression and other depression episodes, such as Japan's "lost decade."

Financial Crises and Assets as Media of Exchange

We construct a monetary model of financial crises that can explain two characteristic features of the global financial crisis in 2008/2009, namely, the widespread freeze of asset transactions and a sharp contraction in aggregate output. We assume that the assets, such as real estate, work as media of exchange on a de facto basis in the goods market. In the financial crisis, excessively indebted investors hoard the assets hoping for a miraculous rise in their value (risk-shifting behavior), although the asset hoarding hinders the assets from working as media of exchange in the goods trading. Accordingly, the asset hoarding causes the disappearance of a significant portion of broad "money," which directly results in a contraction in aggregate production. Since the root of the problem is an external diseconomy caused by excessive indebtedness of investors, fiscal and monetary policies and debt reduction for investors have almost equivalent effects in terms of recovery efforts in a financial crisis.

Transaction services and asset-price bubbles (Revised)

This paper examines asset-price bubbles in an economy where a nondepletable asset (e.g., land) can provide transaction services, using a variant of the cash-in-advance model. When a landowner can borrow money immediately using land as collateral, one can say that land essentially provides a transaction service. The transaction services that such an asset can provide increase as its price rises, since the asset owner can borrow more money against the asset's increased value. Thus an asset-price bubble can emerge due to the externality of self-reference, wherein the asset price reflects the transaction services that it can provide, while the amount of the transaction services reflects the asset price. If the collateral ratio of the asset (¥ó' and money supply (m) are not very large, a steady state equilibrium exists where the asset price has a bubble component and resource allocation is inefficient; if ¥ó'and/or m become large, the bubble component of the asset price vanishes and the equilibrium allocation becomes efficient. The paper shows that in the case where the equilibrium concept is relaxed to allow for sticky prices and a temporary supply-demand gap, an equilibrium exists where a bubble develops temporarily and eventually bursts.

Emissions Standard System: A monetary regime for provision of global public goods

This paper theoretically examines an imaginary monetary regime in which the private provision of global public goods that reduce greenhouse gases ("emissions reducers," e.g., forests) is enhanced and the public goods are held in the private sector as monetary assets. We consider a monetary regime where the government or the central bank makes public goods a means of payment by committing itself to conversion of emissions reducer into cash (and probably by adopting appropriate banking regulations). Using a simple cash-in-advance setting, we show that the monetary regime internalizes the externality of public goods by endowing them with a private function as a means of payment. In the monetary regime, private agents buy and hold emissions reducers voluntarily, and the government need not impose caps on emissions nor pay any costs for public goods provision. Moreover, in an economic boom when greenhouse gas emissions increase, emissions reducers may also increase automatically. Due to the network externalities of money, emissions reducers may become used as money internationally and thus the international free-rider problem may be mitigated. Our results imply that the monetary regime may be a promising extension of existing policy plans for global warming.

Deflation Caused by Bank Insolvency

The Japanese economy has suffered from persistent deflation since the mid-1990s, when the banking system fell into serious undercapitalization. In Germany and in China, worries about impending deflation have emerged, along with fear of prospective or hidden bank insolvency. In this paper I present a simple model in which bank insolvency causes deflation. During a period of bank insolvency, bank deposits in excess of bank assets continue to exist if the government (implicitly) guarantees them. I assume that bank deposits cannot exceed a certain multiple of the monetary base and that the government is prohibited to expand fiscal expenditures. A government that guarantees unbacked bank deposits without recapitalizing an insolvent banking system is forced to set the nominal interest rate at zero and to let the price level fall.

A Theory of Banking Crises (Part 1)

In order to protect the public's confidence in deposit money, governments usually guarantee bank deposits implicitly or through an explicit deposit insurance system. Thus bank insolvency does not induce immediate bank runs. In many episodes of banking crises, several years passed quietly after bank insolvency had occurred, with the insolvency continuing to develop under the surface, and the rash of bank failures broke out only when the bank insolvency exceeded a certain level. In this paper I present a simple model that describes the dynamics of bank insolvency in a form that eventually results in banking system failure or bank recapitalization by the government. The main results are as follows: (1) The government cannot indefinitely postpone recognizing the fiscal loss associated with bank insolvency. (2) The consumption level is too high (low) before (after) bank recapitalization compared with the optimal level. Thus the price conditions become deflationary (inflationary) before (after) bank recapitalization. (3) Social welfare decreases as bank recapitalization is delayed.

Debt Deflation and Bank Recapitalization

During some recent financial crises, the majority of domestic banks -or indeed the entire banking sector- became insolvent. We have analyzed the welfare effects of policy responses to bank insolvency by examining a modified version of the Diamond-Rajan model, introducing a fiat currency. The sources of inefficiency in our model are the "moral hazard in banking" and the "premature liquidation of bank assets". The model assumes that banking system insolvency is caused by an exogenous macroeconomic shock that destroys a portion of banks' assets. If the government does not intervene in very severe cases of bank insolvency, a fire sale of all bank assets can occur along with dis-intermediation of the economy and falls in price levels (debt deflation). We have analyzed the consequences of the following three different policy responses to bank insolvency: (1) providing deposit guarantees (without immediate recapitalization), (2) providing unlimited liquidity support, and (3) effecting bank recapitalization through either cash creation (monetary policy) or bond issuance (fiscal policy). In doing so, we showed that bank recapitalization by fiscal measures provides the optimal solution. Our findings imply that Japan's protracted recession and deflation problem may have been caused by an inappropriate policy response to bank insolvency.